That’s the fear of some investors in the wake of bond market turbulence this week after United States central bank boss
Ben Bernanke
indicated that the bank could start winding down its $85 billion-a-month bond-buying program later this year and end it altogether by mid-2014.

Bernanke’s comments triggered a sharp fall in bond prices and a spike in bond yields. Yields on benchmark 10-year US government bonds jumped 14 basis points to hit 2.36 per cent, their highest since March 2012 and well above their level of 1.6 per cent at the beginning of May.

Some analysts worry that the US central bank’s decision to start winding back its monetary stimulus could wreak havoc on global financial markets. They remember all too clearly what happened in 1994 when a surprise decision by the US Fed to start tightening monetary policy after prolonged easy money prompted a bloodbath in US bond markets.

Beginning in February 1994, the US central bank tightened by 300 basis points over the next 12 months, subjecting US bond investors to their worst year in modern history.

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Emerging market investors were also hard hit. In what became known as the Tequila Crisis, Mexico’s currency plunged by about 50 per cent in six months, causing its foreign debt (largely denominated in US dollars) to swell enormously and push it into a deep recession.

Investors are concerned emerging markets are once again showing signs of stress. Although most emerging markets now have a much more solid funding structure than two decades ago, they’ve been pummelled by the latest rise in US long-term interest rates. In the past few weeks, the emerging market bond index (EMBI) has dropped 10 per cent.

Same same but different

But other analysts believe fears of a 1994-style rout are overblown, pointing out this situation is different.

Back then, the US central bank had only one monetary policy tool – short-term interest rates – to boost or slow economic activity. But the Fed was too slow to raise interest rates as the US economy picked up speed because it was keen to provide support to the troubled US banking system (which had just emerged from a major credit crunch).

When inflationary pressures took hold, investors feared the US central bank would be forced to increase rates sharply, and, in anticipation, they dumped their bond holdings. This time, however, the US central bank has been determined to stay ahead of the curve when it comes to tightening monetary policy.

For the past two months it has been drawing attention to the risk that excessive monetary stimulus could create asset bubbles and hinting that it will soon begin to wind back its massive bond-buying program.

The Fed’s view is that the US economy is now resilient enough to allow it to begin slowly withdrawing some monetary stimulus.

After all, private sector economic activity is picking up (the US central bank is projecting growth of 3 per cent to 3.5 per cent next year), while the budget deficit is shrinking. According to the Congressional Budget Office, the deficit for this financial year (which ends on September 30) will fall to about $US642 billion ($677 billion), around $US200 billion lower than the agency estimated just three months ago.

Even more importantly, the US central bank now boasts two financial instruments for fine-tuning the economy: bond buying and interest rates. The Fed’s bond-buying program – it has been buying $US40 billion of mortgage-backed securities a month since last September and last December added $US45 billion of long-term US government bonds to its monthly shopping list – injects liquidity into the financial system and boosts economic activity by pushing longer-term interest rates lower.

Meanwhile, it has kept its key interest rate close to zero since December 2008.

Waning inflation marks the spot

Analysts say the challenge the Fed now faces is to convince investors that there is a huge difference between these two monetary policy tools.

Although it is likely to start winding back its bond-buying program between September and December this year, it is unlikely to move short-term interest rates until 2015 at the earliest. What’s more, the Fed has a huge degree of flexibility in deciding how to proceed in winding back its bond-buying program.

If US economic growth disappoints, or if bond and equity markets overreact to the prospect of tighter liquidity, the Fed can easily ramp up its bond purchases.

Of course, another key difference with 1994 is the lack of inflation.

In 1994, investors were spooked by a sudden inflation scare, which was triggered by a sharp surge in commodity prices.

Now, however, the Fed has to contend with waning inflation. Indeed, its favourite measure of inflation (the price index for personal consumption expenditures excluding food and energy) is showing a year-on-year rise of 1.1 per cent, well below the bank’s 2 per cent target.

As a result, long-term US interest rates, in real or inflation-adjusted terms, are now positive for the first time in two years.

This weak inflation backdrop prompted
James Bullard
, the president of the St Louis Fed, to dissent from the Fed’s latest policy statement.

Instead of withdrawing monetary stimulus, he argued that the lack of inflation should prompt the US central bank to adopt an even more stimulatory policy, in order to “signal more clearly its willingness to defend its inflation goal".